The number of ‘fallen angels’ dropping into the Numis Smaller Companies index has hit a record high and could provide investors with seven over-sold investment companies ready for a rebound.

An annual review of the small-cap index by Paul Marsh and Scott Evans of the London Business School showed 29 companies last year tumbled into the benchmark, which measures the bottom 10% of the UK stock market. They now account for over a quarter, or 26%, of its constituent stocks.

This came amid a tough year for the index, which slumped 17.9% as investors dumped smaller companies fearing they would struggle with rising interest rates and energy costs. 

Professor Marsh, an architect of the index launched under Hoare Govett in 1987, said the poor performance ‘was to be expected’ given ‘equities generally perform poorly in hiking cycles, but small-caps tend to do worse, with a negative small-cap premium’.

However, Marsh maintained that since the benchmark’s inception UK smaller companies had beaten FTSE 100 blue chips by 3.1% a year on average, which he said showed that ‘investing in small-caps over the long run has been a winning strategy’.

Looking at data since 1956, Marsh admitted buying the fallen angels of the previous year had on average produced ‘slightly negative’ returns. However, he explained the strategy did work after the worst years like 2022.

‘The returns are significantly positive when the fallen angel cohort is substantial and follows a sharp decline in markets like today,’ he said.

‘This year’s fallen 29 have already outperformed the broader market year-to-date by about 10%, indicating that 2023 might be the year of the fallen angel,’ he added.

Of interest to readers of this website is the fact the list, which the FT’s Claer Barrett highlighted at the weekend, includes the following seven investment companies.

Real estate

Assura (AGR ), the £1.6bn real estate investment trust (Reit) of primary care properties, tumbled into the Numis small-cap index after interest rate rises soured sentiment towards the sector in the second half of last year, with the selloff intensifying after the September ‘mini’-Budget which caused gilt yields to spike. More than a fifth was wiped from the shares last year to leave Assura on an unsual 9% discount and 5.6% yield.

A trading statement last month showed that despite a 7% drop in property valuations in the last quarter of 2022, the company has a good pipeline of acquisitions and developments and pointed to the fundamentally positive backdrop it enjoyed from an underfunded NHS that needed the modern infrastructure that companies like it can provide.

Rival Primary Health Properties (PHP ) also joins Assura as a fallen angel after a one-year 17% drop that leaves the shares offering an 11% discount and 5.9% yield, according to Numis data.

Private equity

Bargain hunters have rich pickings in a private equity fund sector where, excluding the mighty 3i Group (III ), which reported a strong third quarter last week, there are a dozen closed-end funds languishing on an average discount of around 27% to net asset value.

The fallen angels strategy could help winnow the list to two just targets, however. For example, the formerly highly-rated HgCapital (HGT ) has fallen 14% in the past 12 months leaving the shares 20% below NAV, a gap that could narrow if investors reconsider its £2bn collection of accounting software providers. Their reliably recurring revenues make them a completely different proposition from the unprofitable technology startups that bore the brunt of last year’s slump.

Pantheon International (PIN ), a £2.4bn investor in specialist private equity funds, has, like the others, also seen its chronic share price discount widen to 43% despite a good underlying investment performance over three, five and 10 years.

Numis Securities investment companies analyst Priyesh Parmar said discounts across the listed private equity sector remain ‘highly attractive and are reflecting an excessive amount of bad news, indicating that investors have little faith in portfolio valuations and are expecting further falls given volatile equity markets’. 

Equities

Mercantile (MRC ) offers a good double discount on the potential recovery in UK mid-cap stocks in which it invests. After a 26% fall last year, shares in the £1.9bn portfolio run by Guy Anderson and Anthony Lynch at JPMorgan Asset Management stand 13% below net asset value, although that is in line with their one-year average after a 10% rally in the past month.  

Mercantile’s performance has suffered in recent years from investors’ neglect of domestic UK stocks, but over 10 years it has returned 137% including dividends, outpacing the 88% total return of its FTSE 250 benchmark.

Witan (WTAN ) could make an interesting play on global stock markets which it invests through a panel of eight external fund managers, including Lindsell Train, Artemis and Veritas. After a tough time since the pandemic, the shares have returned just 12% over three years and trail on a slightly wider-than-average discount of 10% to NAV. They have started to do better in the past six months with chief executive Andrew Bell hopeful this will continue as the ‘headwinds of 2022 subside’.

Alternatives

Shares in Sequoia Economic Infrastructure Income (SEQI ) are less volatile than the others in this list, but still have had a tough 12 months as rising interest rates and a small exposure to non-performing loans worried investors in the £1.6bn private debt fund. The impact of rising interest rates does not make a lot of sense as 59% of SEQI’s assets are in floating rate loans whose coupons rise with base rates. The increased interest stream saw cash cover for its quarterly dividends jump from 1 to 1.4 times in the half-year to September, giving the board confidence in November to lift the payout target to 6.875p. At yesterday’s closing price of 85.9p, SEQI stands on a wider-than-average discount of 7% and a forward yield of 8%.